The inventory conundrum2 min read . Updated: 23 Dec 2009, 12:35 AM IST
The inventory conundrum
The inventory conundrum
Inventories are closely linked to a business cycle. When an economy is in a downturn, sales fall and stocks pile up with manufacturers and dealers. Production is then slashed and inventories fall. As the cycle turns and demand comes back, inventories rise.
The chart shows the change in the value of stock over several years. Notice how in 2001-02, during the depths of another downturn, inventory contracted for all four quarters. It began building up again in 2003-04. Notice how, as a boom gathered momentum, so did the addition to stocks.
But when the manufacturing sector—most closely linked to levels of inventories—started to falter at the beginning of 2008-09, the addition to stocks continued to be extremely strong. More surprisingly, even during the December 2008 and March 2009 quarters, additions to stocks continued to be robust.
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The conundrum is: Why did firms not cut inventory this time, although they had done so during the last downturn? Could it be because the economy was not as badly hit?
Manufacturing growth was much lower in 2002-03 than in 2008-09. Could it be because the crash happened so swiftly that businesses were caught unawares, and even though they slashed production, inventories continued to pile up?
In the September quarter, however, while industrial production went up sharply, additions to inventory fell drastically. Firms were ramping up production to take advantage of improved demand, but because they already had a high inventory backlog, they didn’t add to their inventory substantially.
In fact, inventories had plummeted even more dramatically during 1997-98 and 1998-99, when manufacturing growth at constant 1993-94 prices was 1.5% and 2.7%, respectively. Inventories were volatile during those years, with huge contractions followed by equally large rebounds. One reason why inventory cycles are not so volatile now is because companies have become far more efficient in their working capital management and keep lean inventories.
Interestingly, data from the HSBC Markit Purchasing Managers’ Index (PMI) on finished goods stocks in the Indian manufacturing sector tell a different story. This sub-index expanded (with readings above 50) till February 2008, stayed level in March 2008, then contracted for four months before pausing for breath in August and September 2008.
The Lehman Brothers Holdings Inc. crisis then hit and the level of finished goods contracted for another six months before starting to expand in April. It paused again in June and contracted between July and September before stabilizing in October and November.
Once sales pick up, firms gain confidence and start stocking up once more. So far, the PMI does not show that has occurred. But if the growth in demand continues, it’s very likely we’ll see a rebound in inventory growth soon, reinforcing the strength of the recovery.
Graphics by Sandeep Bhatnagar / Mint
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